With interest rates remaining low it is hard to find safe places to invest your money. While a certificate of deposit (CD) can provide a safe and insured return, a 1%, or even 2.5%, yield is not really exciting. An alternative to a CD or high yield savings account are dividend stocks. Investing in the top dividend paying stocks can provide a steady income stream for many years with the potential for capital gains over time.
There are plenty of stocks that pay dividends; however, they are not all created equal. Some stocks offer yields above 10% which may seem enticing but can actually end up being very risky investments. On the other hand, investors who buy stocks with low yields may feel like they are wasting their time which isn’t always the case. Many low yielding stocks actually make for great investments.
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Use Financial Ratios to Vet Dividend Stocks
Here are 5 financial ratios that every dividend investor should use to help make investment decisions. Using all or a combination of these calculations can help investors filter out the bad dividend stocks from the good ones.
1 – Dividend Yield
The dividend yield (or current yield) is the most commonly used ratio for income investors. The current yield is calculated by dividing the past 12 months worth of dividends paid to common shareholders by the current share price. For example, if a company paid $1.00 in dividends over the past 12 months and is currently trading at $25.00 per share, the current yield would be 4% ($1.00/$25.00).
While the dividend yield is an important measure of any income stock, there are a few flaws with this calculation. First, the equation uses past dividend performance against the current share price. Since there is never any guarantee of future dividends the current yield could be skewed if the company decides to make a cut in its dividend payments.
Another concern with using the current yield is that it does not represent the return on investment from stocks you already own. The average cost per share of a stock owned by a dividend investor is probably different than the current share price. In this case the dividend yield would not represent the true total return.
Overall, the dividend yield can be a useful investment tool despite its flaws. Investors must recognize the shortcomings of the ratio and account for them when performing stock analysis and research.
2 – Payout Ratio
The dividend payout ratio measures how much of a company’s earnings are being used to pay any common stock dividends. This is an important ratio for a dividend investor to use as it provides helpful insight into the legitimacy of the current yield of the company. For example, a company with a high payout ratio (i.e., 80%) will likely not be able to sustain that dividend based on the current earnings.
In order to find the top dividend stocks investors should look for companies who maintain a dividend payout ratio around 50%. From year to year there may be special circumstances that push up this ratio for a company, but long term the results should be consistent. This helps ensure the company is well positioned for future growth; growth is a good characteristic of a dividend paying stock.
3 – Yield On Cost
A dividend investor won’t find the yield on cost (YOC) on any financial website or in the business section of their newspaper. Instead, they must calculate this ratio on their own as it represents the dividend yield of the investor’s position in the stock, not the current share price.
As explained above, the current yield of a stock is calculated by dividing the dividends paid by the current share price. Since a dividend investor probably didn’t purchase their position in the stock at the current share price, the current yield is not helpful when determining their personal return on investment from dividends. That is when the YOC can come in handy.
The yield on cost is especially important to a dividend investor if they overpaid for a stock. For example, an investor may own a stock that trades at $25 per share and paid $1 in annual dividends for a 4% yield. A yield like that isn’t too bad in today’s economy. However, if the dividend investor overpaid for the stock and purchased it at its peak around $35, the yield is not as impressive. In this case, the investors yield on cost would only be 2.8% even though the current yield is at 4%.
In the scenario above the investor may decide to cut their losses based on the YOC results and reinvest elsewhere.
4 – Price-to-Earnings
The price to earnings ratio (P/E) is one of the most common financial calculations used by all investors (dividend focused or not) today. The ratio is calculated by taking the current share price of a stock and dividing it by the reported earnings over the past 12 months by the company. This calculation is also referred to as the trailing P/E because it uses past earnings results. There is also the forward P/E which uses earnings estimates for the next 12 months instead of past earnings.
Using the P/E of a stock can be handy for a dividend investor. Dividend stocks are usually not in the growth stage of their business cycle otherwise the money paid out in dividends would be better spent reinvesting in the business. Thus, they should have reasonable P/E value. There is no need to overpay for a dividend stock. The price-to-earnings ratio can help give the investor what they need to filter out overpriced investments.
5 – Dividend Growth
A dividend investor should not only look at where a stock is heading but where it has been. Finding companies with consistent dividend growth rates from year to year is a good sign of a well run company. While it is no guarantee of future growth, past performance is still a good sign.
Investors can find various dividend growth calculations (e.g., 5 year, 10 year) through their stock broker or other financial websites. The growth rate can also be calculated by hand once you identify annual dividends for the years you are interested in researching.
Final Thoughts on Ratios for Dividend Investing
There is no magical equation that is found in the 5 ratios listed above. They all provide useful information for dividend investors to use in their stock analysis and screening. Each has its own shortcoming and none should be used by themselves alone. The best option is to use each of them in your analysis and understand what the overall results provide.
What other dividend ratios do you use in your analysis?
John Schroeder is a personal finance blogger who enjoys writing about passive income, debt-free living, and financial independence. He also enjoys sharing his experiences in raising a family on a single income, while his wife stays home with their two children. Aside from writing about money, he is an avid runner and enjoys spending time outdoors with his kids.